Bond downgrades may hurt Wall Street more than some think

Changes in bond ratings may make it more costly for banks to do business and could halt the rally in their shares.

There seems to be little that can stop the bank stock rally.

Last week, when Moody’s said it was considering downgrading by as much as three notches the bond ratings of the U.S.’s largest financial firms the market basically shrugged. Shares of Bank of America (BAC), Citigroup (C), Goldman Sachs (GS) and other financial firms actually rose on the day of the news. So there.

But some analysts think the debt downgrades if they occur could end up being a significant blow to the bank’s Wall Street businesses. Analyst Brad Hintz of Sanford Bernstein says he is likely to lower his earnings numbers for all the banks, though he’s not sure how much yet.

Ratings actually don’t matter that much when it comes to things like mergers and acquisitions; stock and bond underwriting; asset management and brokerage services. Those businesses don’t typically require a lot of borrowing. But in the run-up to the financial crisis, Wall Street got into a lot of borrowing-intensive businesses. Dodd-Frank has forced the banks out of some of those businesses – proprietary trading to an extent – but not all of them. In fact, what the potential ratings downgrade points out is that Wall Street has mostly been loath to exit these businesses, and relatively low-interest rates have made that possible, along with checking accounts, on which banks pay almost nothing for access to our money.

JP Morgan Chase (JPM), for one, maintains an enormous book of derivatives, which are contracts that allow people to hedge and bet on price swings in commodities, interest rates and other areas. It gets more costly to write those contracts if you have a lower credit score. For all the banks, derivatives can make up as much as 15% of their profits from fixed income capital markets, and 20% of equity capital markets. So that’s the part of the business that will be shrinking. Also, making markets in illiquid securities, like sub-prime mortgage bonds, for which there seems to be an increased interest, or small-cap stocks, becomes more expensive to do because you have to borrow money to hold on to those securities.

What’s more, the ratings changes could also shake up who does what on Wall Street. And we may already be seeing that. Goldman Sachs and JP Morgan are likely to see less of a ratings cut than Morgan Stanley (MS), Bank of America and Citigroup. That will put pressure on market making and derivatives parts of the later, and drive more of that business to Goldman and JP Morgan. Hintz says the capital market business of Morgan Stanley and Bank of America, which is the former Merrill Lynch, have already been struggling. But the fact that Morgan Stanley recently nabbed the top slot on the Facebook IPO could just be another sign of how Wall Street’s businesses will shake out.

David Hendler who follows the banks for CreditSights says the Moody’s downgrades are less of an event than Hintz and others think. Banks have known the downgrades are coming and are prepared for it. What’s more, he says bond investors care less about ratings than they used to and will continue to buy up bank debt. But recently, the value of bank bonds have been falling even as the shares of financial firms have continued to rise. That’s a concern. Bond investors are typically a more cautious bunch than stock market investors. And being cautious on the banks in the past few years has generally paid off. We’ll see if that has changed.

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